Trey Lockerbie (04:02):
How old were you when this happened?

David Schawel (04:05):
I was only three years out of undergraduate.

Trey Lockerbie (04:09):
Yeah, so like early 20s.

David Schawel (04:11):
Yeah. It was interesting because nobody really knew what was going on at the time. And everything was unraveling. And I think people didn’t know at the time how bad it was going to be. And so I really had to dig in. I started reading prospectuses, and modeling cash flows, and having to meet with the regulators that came in, the Fed, and FDIC, and so forth. And they surely didn’t know what was going on. So it was really quite an interesting environment of having to learn in the biggest financial crisis the country had seen since the great depression. So it was quite the introduction to credit and fixed income in general.

Trey Lockerbie (04:54):
The way you described your boss, Richard, telling you that they were having some problems, he sounded so casual in your delivery there that I found it humorous. I was envisioning like the boss from Office Space with a coffee mug, just being like, Hey David, we’re having some issues here.

David Schawel (05:10):
And I think that there was hope that things would turn around, but I felt like the more you peel back the onion and the more you realize that these were going to be very problematic, and the way that a lot of these mortgage backed securities are structured is there’s different tranches and subordination. So a lot of the bonds where if you sat in the senior part of the capital structure, they might’ve been okay even if many of the underlying loans were bad. If you sat in more mezzanine and junior positions, you could be wiped out, let’s say of 20 or 30% of the loans went bad and started to take losses. So it wasn’t just the underlying credit, but where you sat in the capital structure.
And basically going back to that environment, is you would get paid, let’s say another 10 or 15 or 20 basis points to assume a lower tranche in the structure of these bonds. And so they got paid in hindsight, what was a very meager additional interest stream just to take on incremental credit risk. But the bank ended up raising additional capital. We made it through. And I continued to manage the portfolio for Square One, which was kind of the kitchen sink of credit, whether it was mortgages, investment grade corporate bonds, municipal bonds, preferred stock, some high yield bonds, and kind of everything in between. So it was kind of interesting foray into the credit markets.

Trey Lockerbie (06:48):
You mentioned some of the clients not paying their mortgage. My understanding was a big impetus for that crash was not only CDOs, but essentially these variable interest rates that were attached to these mortgages, where there was sometimes sort of, I think even a zero interest rate for a number of years, and then it would pop to five or 6%. And that’s when a lot of families ran into trouble. They maybe expected to have more income by that time. And didn’t, and then they started falling short when you were starting to dig into loan by loan, et cetera, what was going bad, is that the main takeaway that you saw happening?

David Schawel (07:23):
Well, there were certainly some of that. There was a lot of different programs. And I think, just for the listeners to highlight kind of what was happening, if you go back to the pre-financial crisis over half of the mortgages being originated were what you’d call non-agency mortgages. And basically what that means is that those mortgages did not have the backing of the GSEs, meaning Fannie, Freddie and [Ginnie Mae 00:07:50]. They were not government backed. And if you go to today, it’s kind of all the way at the other end of the spectrum, being almost probably 95% government backed in the private.
The non-agency market as a pretty small sliver of the overall market. But at that point in time, pre crisis, there was a lot of creative programs that were put into practice to get that affordability down, to get those teaser rates. And there was a number of different programs that would get those. So the underwriting and the fact that more than half the originations were outside of the GSEs, really led to a lot of creativity and unfortunately poor underwriting. And that led to a lot of the problems.

Trey Lockerbie (08:39):
So you’ve moved on from working at a bank. But the banking sector is interesting in a lot of ways, somewhat appealing, and somewhat not, given obviously the interest rates are still very low. But then you have the fact that you’re basically backstopped by the Fed and you’re able to sell your bonds with the top bidder. And I’m curious, what is your general take on the financial sector in today’s environment?

David Schawel (09:06):
Well, the financial sector as a whole, there’s kind of a good and bad to it. So you mentioned the fact that the fed has embarked in kind of unprecedented monetary policy, fed funds being very low, and there’s a lot of facilities out there that banks can borrow from, whether it’s the discount window overnight, that or a lot of other programs that they’ve come out with since. So I think from a funding perspective, from a borrowing perspective, it’s a lot easier. But obviously the problem right now is that to find earning assets at any type of yield is a lot more challenging. Honestly, I think that the banking sector is fairly low risk right now in that capital ratios are pretty high, banks have a lot of sources of liquidity and funding, other regulators are a lot stricter on what types of loans can be originated. And I think the asset quality is pretty good. And I think a lot of the risk in lending is kind of moved out of the regulated banking sector and kind of more to the non-bank shadow banking segment.

Trey Lockerbie (10:15):
With that I’d like to kind of fast forward now to today, or at least 2021, because what you were just saying is obviously asset prices are at high levels, all time highs. What was your playbook going into 2021? Because obviously things were high even at the end of 2020. I’m curious, how were you approaching 2021? And how has it potentially changed, if at all?

David Schawel (10:39):
If you went back to the end of last year, the 10 year treasury with a 92 basis points. We had not had the Georgia runoff yet. And I think there was a lot of uncertainty just as far as who is going to control Congress. And at that point, what type of fiscal spending would come to be? So coming into there, interest rates were pretty low. I think the general consensus on the street was that we’d probably have a split Congress. The Republicans would probably keep control of the Senate, and the Democrats would have the house, and maybe president Biden could get through some things, but probably not aggressively. And I think that that playbook kind of changed once the Dems swept the runoff in January. And you start to see a lot of the cyclicals rally interest rates started to pop.
They went from, I think the end of September last year, and you’re at 65 basis points, to they peak at just about 175 at the end of March this year, so it was over a hundred basis point rise, and really rotation into cyclicals. So I think the speed at which that happened was probably a little bit surprising for a lot of market participants. But the market and not been accustomed to a scenario where you had not only monetary policy being easy, but also fiscal spending. Obviously during the COVID pandemic, there was the emergency spending, and PPP, and different types of stimulus.
But obviously since then, they’ve also enacted other programs. So the type of fiscal spending to plug the demand gap, that happened as the economy went through a standstill, something we really haven’t seen before. So I think the combination of all that and the additional spending really gave a lot of fuel to the market, and for a while led to a pretty big rotation in interest rates going up, cyclicals rallying, and no kind of a change in market leadership, which probably lasted until May and early June when the Delta variant fears came back and interest rates have kind of given back some of their gains in yield since then.

Trey Lockerbie (13:04):
The S&P 500 is up a little over 20% year to date, [Russell’s 00:13:09] up 16, Nasdaq’s up 21 just year to date. And this is at the time of recording obviously, which is early September. What is the indicator that has recently made you sit back in your chair and just say, wow. Given where you maybe thought we’d be at this point last year, and what has transpired, is there anything, any metric that’s stood out to you that’s kind of blown your hair back a little bit?

David Schawel (13:35):
No, it’s a fair question. I think the thing that’s been most amazing this year has been the revision in earnings for the market. So if you think about coming into the year, I think the consensus for the S&P earnings for 2021 is probably around $160 per share. And typically, economists and sell side is pretty optimistic on that. But in this case the market has dramatically underestimated just how much the S&P would earn this year. And now fast forward to, as you said, we’re in early September, the market is assuming that the S&P can earn north of $200 per share. So really, there’s been a significant push upward in earnings estimates. And I think it’s worth looking into why that’s happened. Your next question is probably going to be, well, why have earnings come in so much higher than expectations?

Trey Lockerbie (14:46):
Bingo.

David Schawel (14:48):
And particularly with all the headlines about rising costs, input costs are going up, whether that’s transitory or permanent is yet to be seen, labor costs are going up. So how in the world has S&P earnings has gone up this much? And I think the answer is twofold. One, top line growth has really exploded. Revenue growth has really gone up far higher than people thought. And then the second thing is, I think on a cost structure going into COVID last year, I think a lot of firms really right side their business, maybe cut back on different types of expenses that they didn’t feel like were necessary, and maybe probably prepared for an environment where times were probably going to be rough. And I think that seemed pretty reasonable to think in a pandemic that that companies would have to cut their cost structure.
And I think what’s happened is revenues exploded and the cost structures have gone up, but not nearly as much as revenues have. And therefore we’re really at record operating margins. So profit margins are now at record highs despite all of the stuff happening. And so I think most market participants, unless you’re looking at these types of things day by day, are not realizing that this has really been a earnings driven year. I think most people would probably think earnings, maybe they’re up a little bit, but maybe the multiple on the market has skyrocketed, but it’s not really been the case. Earnings have really driven, I think the bulk of this year’s game.

Trey Lockerbie (16:37):
I might possibly one third factor, which is related to what you said, I think. But if you’re looking at the S&P 500, 25% of it is the fang stocks essentially. And so those companies get even more operational leverage because they don’t have a lot of, I want to phrase this right, but it’s not like their costs of goods is actually physical. It’s usually software based. And when everything went online during the pandemic, more or less, there’s this huge gold rush onto Amazon and other platforms because retailers were closed. Do you think that those companies having already high margins got even higher is playing a big factor into the aggregate of the S&P?

David Schawel (17:21):
If you look at the free cash flow margins and all sorts of profitability metrics, and mega cap tech, just head and shoulders above the rest of the market from a profitability perspective. And going back decades, kind of the rest of the market is trading at very similar profit margins. And it’s really been as you’re alluding to, S&P being a market cap driven index, it’s really been a lot of those mega cap technology companies that have driven a lot of the growth and profitability and earnings.

Trey Lockerbie (17:58):
You mentioned that there was a lot of liquidity out there that was piling into the market. I’m curious if you follow how much money is still sitting on the sidelines. Given that we’ve already seen such a huge run-up, are you seeing money still on the sidelines that could potentially enter the market?

David Schawel (18:15):
Well, that phrase is kind of controversial. And I guess there’s a lot of semantics with the whole cash on the sidelines thing, so not to go down that rabbit hole, but I think to answer that question a different way, I think a lot of market participants really feel like equities are the only game in town. Especially with interest rates so low, and on a real basis after accounting for inflation know, yields are negative, treasury yields are negative on a real basis. So I feel like a lot of participants feel like that equities really are one of the only games in town. And sure, they’ve got a lot of indebted gains, but really where else are they going to realistically put this money if they sell? So I think from that perspective, I think that a lot of participants and investors might feel like things are expensive, but they’re also going to tell you that they don’t feel like there’s a lot of good places to go otherwise.

Trey Lockerbie (19:16):
Yeah. As you were saying that I was thinking about your clients, being that you’re an advisory. What’s the sentiment of your client base? Is it very risk on, or is it becoming more risk off as prices have gotten higher?

David Schawel (19:29):
Well, I think it’s take a step back. I think obviously every client situation is different, and we have to account for that. I think the other thing to think about as we try to set up client portfolios to be resilient during a multitude of scenarios. So for instance, we’re not going to try to set up an allocation to win under one or two outcomes and lose heavily under others. I always like to say, we try to be approximately right. We’d rather be approximately right than precisely wrong. That being said, I think your question is clients certainly are surprised that the markets continue to run, and where we are, and to think back where we’ve been a year and a half ago, it’s pretty amazing to see. But I think our goal is to try not to predict the near term, but set up portfolios to be resilient for a lot of different outcomes because the smartest minds in the market, and I’m certainly not one of them, don’t know what’s going to happen.
I try to think about it being more of a scenario analysis. How do we structure portfolios if the market ends up running two years longer than people think versus we really do see the mean reversion and different things, and broad asset prices fall down? So it’s really a balance between that. And then also handling the psychological profile of each client because a lot of investing is really not making bad decisions at the wrong time. You just need to not make poor decisions a couple of times a year. And if you can avoid doing that, then historically you’ve been good. So there’s certainly a psychological component to not only when asset prices are high, but also when they’re low and falling.

Trey Lockerbie (21:28):
I think that’s very wise. I am reminded of something Howard Marks just sat on our show, which was that they were essentially moving ahead, but with caution.. And that resonates with me because I would have told you probably back in 2015 that the market was pretty overvalued. I mean, it’s just, who’s to say, it’s been running for so long, and I hate to beat that drum any more, but there is something you posted on Twitter recently about valuation suggesting that 25% of tech companies, based on the current valuation is suggesting that they might grow at a compound annual growth rate of 15% every year for the next 15 years. So when you see something like that, what do you take from that? I just have to start with you. What do you take from that?

David Schawel (22:11):
Well, to a certain degree, the market is enamored with growth. And I think there’s some reasons why that’s reasonable because I think sometimes growth can cover up a multitude of sins. Take something like Google. Google is still growing. I’m going to pull it up right now. Google is still growing top line, probably over at or near I-Team top line, top line growth. And that’s even $4 trillion plus company. And I think people say to themselves, okay, well if you look out five years at this horizon point, if we feel confident in the durability of their moat in their competitive position, and we can really stand to believe that at this point in time, they’re going to be this big. And that leaves a lot of room for valuations to compress, given a certain growth rate. So looking out in the future, I think investors have become enamored with growth companies.
Now, there’s obviously a downside to this because the other side of the coin would say, well a lot of these companies are being priced to perfection. And they’re being priced that they’re going to grow not only 15% per year, but a lot of these higher buying companies to grow substantially more than that into the far future. And I think the other thing, people bring up interest rates a lot. But when the majority, the bulk of your cash flows are in the future, and that’s the case and growth companies, because they’re longer duration assets, more earnings and sales are going to become in the future. There’s going to be a higher value placed on that when the time value of money has low interest rates, like right now. So certainly in an environment like that, but I really feel like in this environment, a lot of investors are gravitating towards growth covering up a multitude of sins is what I would describe it as .

Trey Lockerbie (24:14):
Very interesting. Yeah. I hear you say that and I’m not sure it was you, but recently on Twitter, I saw someone highlighting the fact that, I don’t know what it was, 10 years ago today or something, the Palm Pilot was valued more than Apple and Google combined, something ridiculous like that. And it’s such an interesting wake up call to say you can project these things out 15 plus years in the future, but then you remember cutting edge tech, as that was back then, and how things can change as drastically as they can.

David Schawel (24:45):
No, you’re absolutely right. And I think if you look across a lot of the high flyers today, and I’m not going to include mega cap when I say this, just because I think mega cap is really not valued nearly as high as some of the small and mid cap high flyers. But they really do have a high, high hurdle to reach when not only meeting these thresholds, but exceeding them. And I think an important thing for listeners to remember is you take a company like Service Now, which is a prototypical SAS company, they’ve just had extraordinary growth.
But they started from such a lower multiple that they not only get the benefit of far exceeding sales estimates, revenue estimates, but they also got the benefit of multiple expansion. Whereas now on some of these, you’re starting from a very full price to sales or price to [inaudible 00:25:46] multiple five years out that it’s not saying that you can’t win, but the bar to having whatever IRR you’re wanting, you’re underwriting for is a lot higher than before. So I think that’s where the margin for error is significantly less than it was five years ago in these spaces.

Trey Lockerbie (26:05):
How are you thinking about allocation and how much are you factoring things like alternative assets or even emerging markets? I’d love to talk about both.

David Schawel (26:14):
Well, I think alternatives just for our particular firm, we do utilize alternative assets. Primarily what we use alternatives for is to add non-correlated or less correlated return streams to traditional assets. So for instance, if we added, and I won’t name names, but if we added certain, for example, a multi-strategy fund that was historically been non-correlated with stocks and bonds, it might produce more steady stream without a risk adjusted [inaudible 00:26:48] going out into the future.
So pretty much the vast majority of our alternatives are not to shoot for market beating returns, but really I kind of refer to it as moving the path out. You can try to optimize for path of assets or portfolios and kind of optimize for destination, but you can’t really do to both. So I would say a lot of the alternatives that we’re including into portfolios are really to smooth out the path, to limit downside, and to provide a better risk adjusted return for the overall portfolio. Now, whether or not these alternatives end up providing that, obviously one can debate, but really the goal is to add some return streams, which are less correlated to traditional stocks and bonds.

Trey Lockerbie (27:44):
Right. I know there’s a Ray Dalio quote about the holy grail of investing is something like 15 uncorrelated bets, as you’re kind of alluding to. And there’s also a wide range of alternative. So I’m wondering if you could give us maybe one example of an alternative that you found maybe recently appealing.

David Schawel (28:03):
I won’t talk specific funds, but I’ll highlight some examples, for instance, in the fixed income arbitrage space. This would be an example of a non directional fund, meaning that if they’re investing in credit and interest rates, in the case of interest rates, they’re not betting on whether interest rates are going to go down or up. And in the case of credit, they’re not necessarily betting on credit spreads going to contract or widen their vice versa.
But one example of a trade might be betting on the mortgage basis. So for instance, you might be betting or investing such that mortgage spreads with Titan, but you might be long, they call it long the mortgage basis, and that you’d be long agency mortgages, and short the risk-free treasuries against it. Or there might be treasury art where you might be buying a nine and a half year treasury and selling a 10 year treasury. Basically trying to find little inefficiencies and arbitrages in the market in which you can exploit. And theoretically, those would not be tied to, for instance, the direction of the S&P 500, or the direction of the Barclays ag, but would have a different profile. So it’s that.

Trey Lockerbie (29:24):
That’s fascinating. I’m wondering how much you might be thinking about emerging markets at a time like this. Is there anything outside of the U S that’s appealing to you at the moment?

David Schawel (29:35):
From time to time we’ll look at that. I think there’s a lot of idiosyncratic risk to those segments, obviously driven a lot by FX and how those currencies do against the dollar, depending on which type of emerging assets. So from time to time, potentially for tactical positions, but I wouldn’t say that we’re investing substantially in emerging markets. But that doesn’t mean, our position is, that’s just my personal preference. But it doesn’t mean that can’t change. Maybe in our eyes, they’d become very attractive in six months or vice versa.

Trey Lockerbie (30:15):
Even your personal preference or your experience, which seems heavily weighted in the credit space, how are you thinking about bonds? I know it’s a generalized question, but how do you think about bonds at a time like this with interest rates as low as they are?

David Schawel (30:27):
I think a lot of investors and maybe casual observers kind of Ooh, and ah over that. But I think that there’s a couple of things at play. One is that there’s a lot of forced buyers of these assets, whether it’s sovereign wealth funds, or central banks, or [inaudible 00:30:49]. There’s a lot of forced buyers of this type of paper. You know, the other thing is obviously demographically, there’s a lot of studies that point to demographics being a major driver lower, not only nominal, but real yield in developed markets, and that’s not a new trend. That’s a 30 plus year trend. But obviously the implications for where risk-free assets trade impacts everything else. There’s no question that how risk-free trade impacts other things. And clearly central banks have become buyers, which has added a different dynamic.
So it’s one of those things, I think used to be a source of income for clients and institutions. And really, I think gone are those days. I think a lot of retirees used to look forward to the ability to buy munis that 4% tax free yields, and that’s not a factor anymore. I don’t think that means that bonds are completely useless. I think if you think about treasuries, particularly the long end of the curve, long treasuries traditionally have been one of the few places that have provided really risk off exposure. So when things get really bad … So it’s interesting, you go back to March, 2020. When things are kind of bad, for instance, investment grade credit, investment grade munis might get a bid, but then if they get really, really bad, so then investors want to dump those too.
So it’s kind of this funny thing where if the markets get bad enough, things that are perceived as safe, munis, investment grade corporates, those asset classes which are originally a flight to safety ended up becoming dumped, so that leaves the depths of last March, treasuries with positive convexity are one of the few things that can really provide diversification and performance when times are really bad. But I think from that perspective, you can’t completely throw away the space as an asset class because there’s certainly benefits to those in adverse market environments.

Trey Lockerbie (33:15):
Now, I’m kind of curious about the negative yielding debt in the world. It’s turned around a little bit. There was about 18 trillion back in December, whereas now it’s something like 12 trillion. But we’re still talking about $12 trillion in negative yield. So not to say you’re invested in that, I’m just kind of curious what your take on that is. What would be the desire to go into something like that?

David Schawel (33:36):
An individual might be able to metaphorically speaking, keep cash under their mattress. But larger institutions might be required to have certain positions and in certain quantities, whether that’s commercial banks or others, they’re kind of forced into holding that. And I think that that is clearly, we’re not in a position where I think we’ve had to entertain really going, they call it negnom, negative nominal, rates. Could that happen in the future? I don’t think it will, but clearly we’ve seen it in the developed world and other G6 countries, and certainly a fascinating thing to look up.

Trey Lockerbie (34:21):
Well, we’re certainly in negative real rate territory at the moment. And a lot of that is due to some of the risks we’ve highlighted with the supply chain issues and the inflation involved. What is the biggest risk for the market right now, in your opinion?

David Schawel (34:38):
The biggest risk, probably something that we’re not thinking about or looking at right now. I mean, traditionally, typically there’s things that come up every year, oftentimes multiple times a year. So are we going to get another triumph? Sure. Is it going to be now, or is it going to be 10% higher from here? Nobody knows. But I think a lot of the kind of obvious one would be, would corporate tax rates go up? That’s certainly something that could happen and become a headwind. Could there be some other strain of COVID? I think the market’s kind of brushed that off to a large degree with the Delta variant, but obviously things could happen. But typically it’s probably an unknown factor that’s driving things.
And markets are never about absolute numbers, but all about, from a relative perspective, what’s going to happen relative to what the market’s expecting. So we still have a recovery and things might still be going good from an earnings perspective or whatever, but maybe relative to what everybody’s thinking, it comes in short due to X, Y, or Z. So that might be a kind of a cop out answer, but most likely it’s going to be something that we’re not thinking about at the moment.

Trey Lockerbie (36:00):
No, I like it. You did mention demographics earlier. And what came to my mind was something I read recently about possibly running out of social security money in 12 years and things like that. Which to me just implies more printing, more devaluing of our dollar and possibly risking our position in the world. At least our credit worthiness. Is that of any concern in your eyes?

David Schawel (36:26):
Absolutely. Do we make capital market assumptions? Yeah. I think that with the United States being a currency issuer, our big constraint on borrowing is really inflation. And that gets a whole nother rabbit hole of what inflation is. But I guess, as far brighter on that topic than I am. But yeah, I think from that perspective, certainly certain market proponents believe that we have a lot of capacity to borrow more to spur demand. And I think others believe that we can’t just run up the deficit that we are without there being some kind of longer-term implications, and that there could be unknown consequences of the types of stimulus programs that we’re doing. But I think the answer is I tried to, we’re certainly going to be looking at all the inflation and demographics situations and fiscal environments. And I think all those things are very important when making investment decisions.
But I think it’s also important not to let my personal opinions on what’s happening with the fed, or Congress, or whatever you might be thinking in terms of … Because, think about it. We can’t control, I was just talking about this with somebody on Twitter, no matter what we think, whether we think policy is the best or the worst or in-between, we can’t control that to a large degree. We can vote, we should, but we can’t control things after that. So from an investor’s perspective, an allocator or active managers, it’s our responsibility to invest in the environment that we have. Back to your original question, certainly those are things that we think about. But whether or not they’re going to impact today, or the near term, or the medium term, is more of the issue.

Trey Lockerbie (38:28):
I like that. And it obviously hearkens back to investing from the ground up. So I’m curious if you had, let’s call it three businesses that you could invest in over the next, say five to 10 years, which companies, in your opinion, are best suited to endure whatever might be becoming over that timeframe and outperform?

David Schawel (38:48):
I’ll give a couple of ideas. First caveat being that we do own positions in these securities. Our firm and myself personally. But I think one company that I like a lot and I’ll talk business-wise. You now, which businesses are going to do well. Whether or not they’ll hedge a little bit, whether or not the stock will actually do well, kind of early to tell. But one of them is a payments company called Adyen. Adyen is a Netherlands based payment company. And so basically what they do is they offer a single payment platform to accept payments anywhere, on any device, whether that’s e-commerce or in person. And the interesting thing about Adyen, and most people haven’t heard of them, maybe more so in the last year or so, but really they were built from the ground up in 2006.
And the reason that the founders did this, because the way that things were set up before, it was kind of a hodgepodge of different systems that were built on old infrastructure. And so a lot of these old payments companies kept acquiring, built it on, cut costs, and really the underlying technology wasn’t really that good. And so I think Adyen, the one platform anywhere, whether you’re in the US or Brazil, whether you’re online or in person, this has really been a great business and a lot of their growth has been in large enterprises, so if you think eBay, Spotify, Uber Etsy, last quarter I think they won Louis Vuitton. And this is a business that I think can really grow revenue by probably 30% per year for the next decade, really.
And not only that, but their cap margins are in the mid sixties, so they’re insanely profitable. Optically the company’s expensive. But I think these trends of kind of unified, and Omni commerce, meaning maybe order online, and then you can return it to the store. Or maybe you go into a shoe store and they don’t have it in store, but then you can buy it in store and ship it home. This omni commerce is becoming more and more part of the way that the world is working, especially post COVID, in an e-commerce boom. And I think Adyen has really positioned at a lot of super, super important secular growth trends. And I think the bet, because obviously you’re a little bit of a higher multiple for this growth, but I think the bet is that with a lot of great companies over time, I think investors can focus too much on the stated valuation and not as much on the optionality that those companies have.
So great, fast growing companies historically have had other sources of revenue and profits that emerge. So for instance, if you went back, I’m not comparing Adyen into Amazon, but the way that a lot of people look at popular growth companies that really have durable growth profiles, is they kind of under price that optionality. And so I think my belief is that a company that’s growing like this and has such great loyalty, and basically less than 1% firm, so much revenue growth coming from existing clients, is that they are going to find new sources of revenues. I believe in the top line growth of their core business. But I think that there’s other things that are going to come about, whether that’s issuance of cards or whatever, that, are going to drive this company into the future. So I think that’s certainly one that I like a lot for the future. And obviously, caveat being that we have owned this company for some time.

Trey Lockerbie (42:53):
What’s your takeaway on the competitive moat exactly? What’s going to stop another payment company to kind of infiltrate their space, given that they’re kind of somewhat regional today?

David Schawel (43:06):
Regional base there, but as far as their growth, they’ve been growing all over the world. But I think because of their technology, they have less fraud, less losses and things like that. And I think that their ability to adapt to the environment compared to a lot of these legacy players, and I think that’s one of the big things, the legacy players are so stale and unable to innovate that, not only with the e-commerce growth going forward, but the existing share that I can take and take from these legacy guys that I think is really underappreciated. I think the second one I’ll say, and then it’ll be more boring, but I don’t think it’s any less important, is Google. I could highlight Google or Amazon because I like them both. But if you think about Google, obviously you have your core business with their ad revenue, which is still growing.
But I think one of the booming things has become YouTube. YouTube, think about an amazing story. YouTube being purchased for, I think it was a billion dollars, and don’t quote me, I’m close, I’m probably within 500 million, but it was a heavily scrutinized acquisition at the time. And interesting thing is people didn’t even know how they’re going to make money. So a lot of people thought it was going to be on the TV aspect. And if you think about how amazing of a business YouTube is, you have people creating YouTube’s own content. They’re the content creators of this and the flywheel effect of more content drawing more viewers, more ads. So that business, I think is just such an amazing company. And I think up until probably the last year or so, it’s really been underappreciated because it’s been kind of hiding under the Google umbrella, but that’s that’s become big.
And then I think after that, to a similar degree, Google Cloud is growing pretty substantially. And it’s certainly, no question, it’s a distant third to AWS and Azure, but there’s limited errors on the cloud provider in the world right now. I think you have to have substantial capital to do that. And I think that they are going to, even if they don’t displace AWS or Azure, I think it’ll be a great business over time, even as the number three player in the US. But not only that, just the amount of free cash flow that they are generating. The last 12 months as of six 30, it looks like close to 60 billion of free cash flow. And so not only does that give them flexibility for acquisitions, which I think they’ve been pretty conservative on, but also buy back. They’ve started to really pull the buyback lever. And I think that they’ve been a lot more conservative on that, at least next to somebody like apple, which is utilized for a lot more. And I think that that’s going to become a bigger and bigger thing.
But it’s hard to believe that a company like Google is still, they do over 210 billion of revenue for 2021, but they’re still growing in the mid to high teens. It’s really remarkable. So I think that it’s a reasonable valuation going forward, and you’ve got quite a few engines underneath their core business that are going to grow. And I think as you look out a couple of years, not that many years, look out a couple of years, with Google’s growth, they’ve certainly re-rated in the last year, but it’s very reasonable compared to a lot of companies in S&P that are trading in the low twenties PE right now with revenue growth. That’s inflation, or just a little bit higher than it placements that you can take Google for similar multiple, a little bit higher multiple. But on a forward basis, significantly cheaper.
So I think that there is some safety in the growth as far as mega cap tech goes. So, what happens with the regulatory environment? I don’t know. Will something happened for some of these? Probably. Will it be punitive to the stock? My guess, probably not, in that it’s probably going to take a long time. And at that point in time, these companies might be a lot larger than they are now, and potentially the pieces might be sold for more than the sum of the parts. So that’s another thing to think about. But certainly at least the headline, that could be a headwind.

Trey Lockerbie (47:59):
Well, David, this was so much fun. Thank you for sharing a few of those ideas. I think they’re super interesting. And this was a very holistic discussion on markets, on companies, on a whole number of things. And so I know our audience is going to glean a lot of insight from it. I really hope we can do this again sometime soon. And I’m going to continue to follow you on Twitter and enjoy your commentary. And I hope we get to do it another time.

David Schawel (48:25):
Likewise, Trey. Thank you for having me on, and I look forward to it.

Trey Lockerbie (48:30):
All right you beautiful people. If you’re loving the show, please don’t forget to follow us on your favorite podcast app so you get these episodes in the app automatically. The guest today and I originally connected on Twitter. So if you want to reach out, you can always grab me at Trey Lockerbie. And lastly, if you’re trying to learn the intrinsic value of a company, look no further than the TIP finance tool. Just simply Google TIP finance, and it should pop right up. And with that, we’ll see you again next time.

Outro (48:54):
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